What is the ‘yield curve’ and why should you care?
“A powerful predictor of future recessions sparked fears of an economic downturn and triggered a sell-off in the stock market.”
—How the finance prof who discovered the ‘Inverted Yield Curve’ explains it to Grandma,” Forbes
Update 8/19/19: The yield curve officially inverted last week. But unless you’re nearing retirement, my advice remains the same: Stay the course and, if indeed there is a recession that deals a blow to your portfolio’s value, give your investments, including your retirement funds, time to bounce back over the next few years. Read on for details.
“The so-called yield curve is perilously close to predicting a recession—something it has done before with surprising accuracy—and it’s become a big topic on Wall Street.”
—“What’s the Yield Curve? ‘A Powerful Signal of Recessions’ Has Wall Street’s Attention,” The New York Times
As chatter about the “yield curve” makes its way to everyday investors with their 401(k)s and IRAs, the big question on your mind might be: If we’re in danger of a recession, should I pull out my investments now before the downturn?
My advice for times like this (and pretty much always): No. Keep your cool and don’t run for the hills (which happens to be a lot like the advice for encountering a mountain lion, minus the yelling and waving of your arms).
Another thought that might enter your mind: What’s a yield curve? It’s essentially a way to look at the difference between short-term interest rates and long-term interest rates. Generally, we want long-term interest rates to be higher than short-term interest rates. Think about it this way: If you had to lock up your money for either one year or five years, you would only choose the longer term if it paid more interest.
What’s happening now is that the yield curve is flattening, meaning short-term interest rates are catching up to long-term ones. Some on Wall Street are really worried that the curve might invert, meaning short-term rates become higher than long-term rates. This phenomenon has historically preceded economic slowdowns and recessions, most recently just before the financial crisis of 2008.
But here’s the thing: Assuming you have been taking my advice and are investing in passive ETFs and index funds, you probably should not change your investing strategy. Over the last 15 years (a span that includes the infamous bear market of 2008), index funds tracking the S&P 500 outperformed over 90% of actively managed funds. If all the financial professionals scrambling to “time the market” can’t beat an index fund, then you probably can’t either. (No offense!) So leave your investments be.
The key with index funds is that they are long-term investments, and returns should be evaluated over the course of many years. There may be periods when the mountain lion takes a bite out of your funds, but over time, they should bounce back.
The exception is if you are close to retirement age and feel like you can tolerate less risk. When you are nearing retirement—flattening yield curve or not—it may behoove you to move some of your investments into lower-risk vehicles such as certificates of deposit (CDs), money market funds, inflation-protected government bonds such as TIPS, or high-yield bank savings accounts. Now, that doesn’t mean you should go cash out your investments ASAP. Think about how much risk you can handle, and then act accordingly. And no matter what, do not cash out your retirement accounts early. That hefty fee will certainly not be worth it.
